Microsoft: A Closer Look at Q2

Microsoft Corporation’s (MSFT) second quarter 2011 results were impacted by the slowdown in the PC market. However, this did not prevent it from beating the Zacks Consensus Estimate on both the top and bottom lines. Revenue and EPS beat by 4.4% and 9 cents (13.2%), respectively.

Revenue

Revenue of $19.95 billion was up 23.2% sequentially and 4.9% from last year. Windows 7, Office 2010 and Kinect were particularly strong.

Management estimates that the PC market (units) was up 2-4% year over year, a significantly slower rate than the 9-11% growth witnessed in the September quarter. Microsoft stated that enterprise was stronger than consumer, similar to earnings reports from other technology majors, such as Intel Corp (INTC). However, premium sales improved slightly to 72%, with consumer accounting for 31% and enterprise 42%.

Revenue by Segment

The Windows and Windows Live Segment generated 25% of quarterly revenue, up 5.6% sequentially and down 26.8% year over year. Excluding $1.7 billion from the year-ago quarter that related to Windows 7 deferred revenue recognition would result in a revenue decline of 2.9%.

Microsoft stated that the company had sold over 300 million Windows 7 licenses to date, with 90% of companies starting the official migration to the platform and 20% of all PCs already running Windows 7.

OEM sales remain a major driver of segment performance and growth in this area was just a point short of PC market growth. Overall, the hardware mix, Windows attach rates and channel dynamics were neutral to OEM revenue growth, while PC market growth was only slightly positive in the last quarter. Additionally, revenue growth was impacted by the continued stronger growth in emerging versus developed markets.

Microsoft was however optimistic about growing opportunities here, given its partnerships with Intel and Advanced Micro Devices (AMD) on the one hand and ARM Holdings (ARMH) partners NVIDIA Corp (NVDA), Qualcomm (QCOM) and Texas Instruments (TXN) on the other.

The Microsoft Business Division, which generated 30% of revenue, declined 18.0% sequentially and grew 27.1% year over year. Both annuity-based (up 9%) and non-annuity (transactional) revenue increased from year-ago levels.

The increase in transactional was exceptional at over 40%, fueled by very strong demand for Office 2010 in both enterprise and consumer segments. Microsoft stated that other products, such as Lync, SharePoint 2010 and Dynamics CRM grew double-digits from last year and stated that in the two weeks since its launch in 40 markets, Dynamics CRM was already wresting share from Salesforce.com (CRM).

The Server & Tools segment, at 22% of total revenue, was up 10.9% sequentially and 14.2% year over year. Here, too, both annuity and transactional revenue grew from the year-ago quarter, with annuity growing 11% and transactional in the high single-digit range.

Enterprise services were up 9%. Virtualization and cloud computing are proving to be very beneficial for Microsoft. Additionally, database is also gaining ground, as evidenced by Dollar Thrifty shifting their pricing system from Oracle’s (ORCL) to Microsoft’s platform.

Microsoft has a very healthy product line (SQL, Windows Server 2008 R2) Azure, indicating that the momentum in its business will continue.

Entertainment & Devices generated 19%, up 106.0% sequentially and 27.4% year over year. The sequential strength was seasonal, and further helped by Kinect (8 million sensors sold in 60 days). Xbox 360 units were 6.3 million, up 21.1% from last year. Xbox Live memberships grew 30% to end the year at 30 million active members. Microsoft also sold 2 million Windows Phone 7 licenses and mentioned that the phone was available at 60 operators across 30 countries, with the ecosystem including 24,000 registered developers.

The Online Services business, or online advertising, generated 3% of revenue, up 31.1% sequentially and 18.9% year over year. We think Microsoft is investing in technology and innovation and it is this work that is improving user experience and helping Bing take some share in the U.S. The partnership with Yahoo Inc (YHOO) is no doubt helping to bring this about, increasing online advertising revenue for the company.

Operating Results

Microsoft’s gross margin of 75.8% was down 484 basis points (bps) sequentially and 515 bps year over year. This is only natural, since the Entertainment & Devices segment (mainly hardware) usually has a stronger December quarter and carries much lower margins than the rest of the business.

Operating expenses of $6.95 billion were up 17.1% sequentially and 1.9% year over year. Consequently, the operating margin dropped 302 bps sequentially and 414 bps from last year. Microsoft is clearly increasing selling efforts, since sales and marketing expenses were up as a percentage of sales from both the previous and year-ago quarters. All other expenses declined sequentially as a percentage of sales.

The operating margin by segment was as follows—Windows 64.3% (a sequential decline of 512 bps), Microsoft Business Division 65.7% (down 53 bps), Server & Tools 40.5% (down 72 bps), Entertainment & Devices 18.4% (down 292 bps) and Online Services -78.6% (up 2,768 bps). The Windows segment operating margins also declined on a year-over-year basis.

The company generated a pro forma net income of $6.6 billion, or 33.2% net income margin compared to $5.4 billion, or 33.4% in the previous quarter and $6.7 billion, or 35.3% in the year-ago quarter. There were no one-time items in the last quarter. Accordingly, the GAAP EPS was same as pro forma at 77 cents compared to 62 cents in the September 2010 quarter and 74 cents in the December quarter of 2009. A lower tax rate helped earnings in the last quarter.

Balance Sheet

Inventories were down 30.7%, with inventory turns jumping to 22.4X. Days sales outstanding (“DSOs”) went to 59, up from 54 at the end of the September quarter.

Microsoft ended with a cash and short term investments balance of $41.3 billion, down $2.9 billion during the quarter. The net cash position was around $3.75 a share. In the last quarter, the company generated $4.2 billion in cash flow from operations, spent $5.0 billion on share repurchases, $1.4 billion on dividends, $1 billion on the repayment of short-term debts, $491 million on capital assets and $69 million on acquisitions.

Guidance Reiterated

Microsoft reiterated the fiscal 2011 revenue guidance of $26.9 to $27.3 billion. No operating expense guidance was provided, so we assume expectations remain unchanged at $26.9 – $27.3 billion, an increase of 4.5% from 2010. Microsoft also expects to spend $2.5 billion on capex and believes the tax rate for the year is likely to be 23-24%.

Our Recommendation

Microsoft appears to be firing on cylinders and we are pretty optimistic about its growth prospects in 2011. However, we think some of the uncertainty in the PC market continues, which is the reason for our conservative Neutral recommendation on the stock. Microsoft shares also carry a Zacks Rank of #3, implying a short-term (1-3 months) Hold recommendation.

MICROSOFT CORP (MSFT): Free Stock Analysis Report

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